The speculators have now learned that all that glitters isn’t gold—or silver. Gold futures dropped 5.8% on Friday, and silver plunged 18%.

Gold closed at $1638, down from the all-time intraday high of slightly over $1,900 just two weeks ago. Silver settled just above $30 per ounce.

Is this the end of the line for the precious metals? Not by a long shot. But it could be an expensive derailment for those who bought on margin. Or for those who received margin calls on other investments, and needed to sell their profitable gold positions to raise cash.

Last week’s market action in the precious metals serves as a reminder that no market is a one-way street. The term “safe haven” as applied to gold means only that it is “safe” when there is a total loss of confidence in all paper money.

And to include silver in the category of “precious metal” is to forget that it also has industrial uses as a significant part of its demand. In an economic slowdown, a decline in industrial demand adds pain on the downside—one reason this column has long focused primarily on gold.

Why Gold?
This discussion about gold is not about trading or market timing. In fact, every time gold has been mentioned here—starting at well under $500 an ounce—the argument for gold has been as a long-term “hedge” against paper currencies.

But all trading markets swing to extremes—based on emotion, and on a rational analysis of the situation. The bears on gold prices have several good, immediate, arguments:

Recession: If there’s a recession, with continuing financial failures and defaults, there’s little chance of immediate inflation. So why own gold?

Capital Needs: Investors ranging from European banks to hedge-fund managers may be forced to liquidate profitable gold positions to raise cash for liquidity purposes. They may regret parting with their gold assets—but they have no choice.

Sentiment: There is nothing more negative than a dream that is dashed. Two years ago, most investors wouldn’t have known the daily price of gold, or cared if it declined. In fact, gold dropped 25% in the fall of 2008—from over $1,000 an ounce to about $750 an ounce. It never made headlines, because everyone was worried about the financial system collapse. Now that gold has become more popular, every decline makes headlines.

NEXT: The Historic Case for Gold

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The Historic Case for Gold
Long-term investors know there is still a bullish case to be made for gold. And current events have only increased the strength of that argument.

It’s a simple fact: No government can “create” gold—but every government can, and eventually will, create paper money (or these days, banking liquidity) to bail out its economy from financial woes.

Until Nixon closed the gold window in August 1971, the dollar was as good as gold—at least for international banking transactions. Central banks that held dollars could come knocking at the Treasury and demand gold in exchange for their paper dollar holdings.

That’s exactly what Charles de Gaulle did when he noticed the US was creating an excessive amount of dollars, leading to inflation. He asked for gold. Nixon slammed the gold window shut—and ever since then, the dollar has not been directly convertible into gold at the Treasury.

In fact, it wasn’t until January 1, 1975 that US citizens could legally own bullion gold or bullion gold coins (as opposed to collector’s coins like the old US $20 gold pieces). All bullion bars and bullion coins and gold certificates were confiscated by the government in May 1933, when holding gold was made a crime.

Owners of those gold coins and bars were given $20.67 per troy ounce in payment. The next year, the official price was raised to $35 per ounce, netting the government a nice profit.

Today, the world’s freely trading markets value gold at over $1,600 an ounce, but the United States carries the gold it owns in Fort Knox at a price of $42.22 an ounce.

During the current crisis, the dollar is seen as the world’s safe haven. But if the world panics out of all currencies, the only way to restore confidence might be to once again make the dollar convertible into gold—at much higher prices!

Gold in the Future
So what is the current “backing” for the US dollar, if it’s still not convertible into gold through the Treasury? The paper money says it is backed by the “full faith and credit” of the Treasury.

For many years, the dollar was officially backed by IOUs from the Federal government—Treasury bills, notes, and bonds. That’s what the Fed took into its portfolio as collateral for newly created credit through its “open market operations.”

Three years ago, as part of the TARP and TALF bailout, the Fed decided it would take mortgage-backed securities from Freddie Mac and Fannie Mae as collateral to save the banking system. And it also accepted a loan portfolio from AIG in exchange for newly created liquidity in the system.

Today, a substantial portion of the Fed’s “portfolio” is holdings of loans that were so bad the banks had to get them off their books!

What’s next? You don’t have to look far to figure that out. Two weeks ago, in an attempt to calm global fears, the Fed announced it would be a source of liquidity for foreign central banks, accepting Euros and other bank assets in exchange for dollars to keep the global system afloat.

So now your dollar will be—partly—backed by loans that European banks made to Greece! They couldn’t get the Germans to back all the potentially defaulting debt—so the Fed stepped in.

That is the greatest argument for owning gold long term. As the legendary goldbug James Dines once said: “When my girlfriend asks for a bracelet made out of paper, I’ll know gold is as good as paper.”